Taxes and interest rates must go up and there have to be deep cuts in public spending, says HAMISH MCRAE

Updated: 02:01 EDT, 1 November 2026 It's not going to work. Our new Chancellor’s Budget was received calmly by the financial markets, but that’s because they know that the Government will be constrained by two things.One is that there have to be deep cuts in public spending in the next couple of years, and I’m afraid almost certainly increases in taxes too. The other is that there have to be higher interest rates, maybe much higher, and that will start this week.The various think-tanks have crawled over the figures and concluded they don’t add up. The independent Institute for Fiscal Studies says there will be a ‘brutal’ spending review next year and warned us to prepare for the worst decade for growth in household incomes on record.Why? The easiest way to grasp what’s happening is to focus on the Government’s inability to keep its borrowing under control. Decision time: Bank of England Governor Andrew Bailey is expected to raise interest rates this weekIn spring the Office for Budget Responsibility forecast the deficit in this financial year would be 3.6 per cent of GDP. Now it expects it to be 4.2 per cent. That’s just for this year. Similar rises are projected through to 2030-31.This can’t go on. The only question is whether the Government takes that brutal action of its own accord, or whether the markets push up bond yields to such a level that it is forced to do so.Remember that already the UK has to pay more to borrow than any other major economy.Now look at interest rates. One way of describing governments that over-borrow is to say they have too loose a fiscal policy, for which they must compensate by having a tighter monetary policy – higher interest rates – or inflation shoots through the roof.The bond markets are doing their job at the long end of the yield curve, raising 30-year borrowing costs to 5.7 per cent, but the Bank of England has held down its short-term interest rate at 3.75 per cent since December. It’s a dead cert that will go up to 4 per cent this Thursday – the first such rise in more than three years.It is the last big central bank to start pushing up rates, for the US Federal Reserve, the European Central Bank, and the Banks of Japan and Canada have all moved. The question is how many more rises will come next year.City economists expect one more, maybe two. Markets are pricing in three or four. It’s possible to see a Bank rate of 5 per cent by early 2028, which will not be good news for John Healey.When his predecessor Rachel Reeves was pushing through huge rises in taxation, at least the Bank was cutting rates, to some extent offsetting the hit to the economy. Firms did their best in the face of those attacks, though some went under and many had to trim staffing to survive. But at least they weren’t being clobbered by high interest rates. That will not be the case from now on.The Bank has a ready-reckoner to work out how changes in interest rates affect overall demand and inflation. Let’s say the base rate goes to 4.75 per cent by next autumn, and that’s the peak. That would cut overall demand by between 0.5 and 1 per cent, taking a year for the full effect to feed through. It would also trim inflation by up to half a percentage point, taking two years for the impact to be felt fully.The trouble is the ready-reckoner doesn’t work as well as it did. One of the biggest transmitters from interest rates to demand is the housing market, but since most mortgages are on fixed rates, changes in interest rates only affect people when their fixes expire. As for inflation, the main driver now is the Middle East conflict and not the cost of finance. Ultimately higher interest rates will curb inflation, but that takes longer than it used to.My takeaway is that short-term interest rates as set by the Bank and long-term rates as set by the bond market will remain higher for longer. We are a resilient lot, and one way or another most of us will cope. But if it’s tough for us, it will be tougher still for this Government. Funny, but I can’t feel too sorry for them.DIY INVESTING PLATFORMSAJ BellAJ BellEasy investing and ready-made portfoliosHargreaves LansdownHargreaves LansdownFree fund dealing and investment ideasinteractive investorinteractive investorFlat-fee investing from £4.99 per monthFreetradeFreetradeInvesting Isa now free on basic planTrading 212Trading 212Free share dealing and no account feeAffiliate links: If you take out a product This is Money may earn a commission. These deals are chosen by our editorial team, as we think they are worth highlighting. This does not affect our editorial independence.Compare the best investing account for you